There are two principal approaches to the modelling of credit-sensitive bond prices. Merton (1977)’s structural approach, recently re-examined by Longstaff and Schwartz (1995), prices corporate bonds as options, given the underlying stochastic process assumed for the value of the firm. On the other hand, the reduced form approach, used in recent work by Duffie and Singleton (1999) and Jarrow, Lando and Turnbull (1997), among others, assumes a stochastic process for the default event and an exogenous recovery rate. Our model is a reduced-form model that specifies the credit spread as an exogenous variable. Our approach follows the Duffie and Singleton ”recovery of market value” (RMV) assumption. As.
